A Bubble too Far

Admittedly an exception to every rule, the very existence of a £23,000 per week property shows in part the mechanisms by which the London market may reach untenable valuations.

LONDON — In the summer of 2005, the Economist magazine led with a story entitled “After the Fall”. The article discussed in detail the problems inherent in what appears to be the most expansive boom real estate has seen since records began, and of all markets studied, only Germany, Japan and Hong Kong were not contributing to the inflation.

According to the report, property values in South Africa increased by 244% between the first quarters of 2004 and 2005. Ireland’s expanded by 192%, Britain by 154% and Spain by 145%. The piece also warned that like Germany, Japan and Hong Kong, some major markets were beginning to “fizzle out” and enter a period of likely decline.

The Economist proposed the possibility that the global economy, not just that of one nation or one region, had become too dependent on the untenable expansion of property values and profit from real estate sales. If the bubble were to burst, it could be the trigger event for the most severe and widespread economic downturn—potentially, a worldwide depression, in technical terms—yet seen in modern times and measured.

It’s a sticky problem, because preventing such an event means first of all identifying the aspects of any given real estate market which contribute to overvaluation and to growth beyond real market potential. Then, it means persuading those with most direct invovlement in that aspect of the market to act to reform their methods or their outlook, to reign in a new kind of “irrational exuberance”.

One worry is that as property values soar, many people will be forced to abandon neighborhoods they have largely built and maintained, possibly stripping the community fabric and undermining the inherent value of a given urban area. That flight would also mean average incomes reach too high a range, and basic services become less widely available and cost of living continues to escalate, further pushing community breakdown and/or flight.

This in turn creates sprawl and can engulf major urban centers and their peripheral suburbs in a crisis of blight and declining value, which combine to threaten the viability of the property-value expansion in the wealthier or booming areas.

Some simply argue it’s a matter of economic cycles. One city becomes the “it” place to be, everyone hears about the “there” that’s there, and values shoot up, while another city falls into a kind of economic stagnation or decline. Many argue the cycles balance out, and overall economic growth is not threatened.

But what if the cycle is less the routine and more one of “boom and bust”, where the downside means ripple effects that make recovery more difficult? This real estate boom is global; it is happening in almost every major city, and in nations like the US, at most levels of the property ladder.

Skepticism about the boom’s sustainability comes from two main factors:

Eventually, there won’t be enough value in actual currency for buyers to sustain the overall value of the property market;

Cost of living is escalating so fast, in so many places, that more pressing concerns than upgrading one’s home or property holdings — like food, healthcare and fuel — will likely outpace the potential for continued growth in property pricing.

One of the mechanisms the Economist cited for driving the boom is speculation: traditionally, real estate is a long-term investment, either for personal use, rent, or resale over time, but new trends show that more and more, it is a commodity traded on the speculation that its value will keep rising.

“Flipping” is the term applied to transactions whereby a property buyer quickly resells the property at a profit, often a signficant profit and often before the property is even completed or used. According to the Economist, as many as half of all new buyers in Miami last year quickly resold their apartments in an effort to profit from flipping; this may have the effect of inflating values of properties at the moment they first become available to be inhabited, hinting at greater likelihood of pricing declines.

The Economist writes: “The most compelling evidence that home prices are over-valued in many countries is the diverging relationship between house prices and rents.” Naturally, if the property owner cannot recuperate enough cash by renting a property to fund its purchase, there would appear to be insufficient funds to maintain growth in property values. Incentives for buying or upgrading decline, and sales themselves do less to spur growth.

The solution to the problem could be linked to lending; if banks are aware of the bubble risk, then they might take a more thoughtful approach to planning for lending for long-term buys, considering the sustainability of property values or the risks posed by increased volatility from excessive financing of “flipping” schemes.

But, it’s clear enough that at some point, overall property values will have to stop growing so radically faster than the overall rate of economic growth, if the slowdown in pricing is to be more akin to a soft landing than a crash.